Working Paper Series 2017 RISK MITIGATION BETWEEN INVESTMENT ACCOUNT PALTFORM AND EQUITY CROWDFUNDING Ahmed Mohamed Mokhtar 1, Associate Prof. Dr. Razali Bin Haron2 1 2

IIUM, Institute of Islamic Banking and Finance Malaysia IIUM, Institute of Islamic Banking and Finance Malaysia E-mails: [email protected], [email protected]

Abstract This paper aimed to study Investment account platform in comparison to equity crowdfunding in the risk mitigation side. Equity finance holds a big interest because it has a substantial amount of risk in moral hazard and market risk. This paper aims to focus at the moral hazard side. The approach of this paper will be based on document analysis and organization comparison based on the premise that risk mitigation in equity finance is different from risk mitigation in credit finance. Holding that assumption, the paper finds that Investment Account platform despite the remarkable achievement in terms of mitigating risk still need more development to substantiate it form credit financing that is used in the banking sector. In these regard, this paper suggest to incorporate a committee in Rating Agency Malaysia that is specialized in investment analysis so that the assessment of start-ups become more relevant rather than having the credit assurance like collateral and credit record. The significance of this paper comes from the pioneering examination of IAP as the first paper to do so and from its recommendations to develop risk mitigation in Islamic equity finance that will allow more institutions to embark on this type of finance to further enhance the value proposition of Islamic finance as opposed to conventional finance.

Keyword: IAP, financial innovations, equity crowdfunding, venture capital, Islamic finance.

Introduction

Working Paper Series 2017 Islamic banking since inception has gained tremendous growth. It is estimated that by 2015 year end, total assets under Islamic financial institutions' management will reach USD $2.143 trillion on average growth of 16.5% yearly. This figure is expected to reach easily USD $3 trillion if the current trend continues. Banking sector accounts for the lion's share of this figure; 75%. The achieved growth and the potential of the industry are not a topic of argument. However, since inception the directions of industry and its functions has been a fertile subject of arguments among stakeholders. Critics about Islamic banks reliance on debt instruments and replication of conventional products has been prevalent since inception. It is undeniable fact that Islamic banks, like conventional banks, have debt as their main product. To get a sense of the problem, one needs to refer to any published Islamic bank's financial statement to see how much of profit sharing products are used in extending financing. For instance, Maybank Islamic has profit sharing schemes representing around 3% to 5% of its financing and advances from 2013 to 2015 other banks' figures hover around the same percentage if not less. Literature Review There is ample literature on moral hazard in equity organizations that is the result of asymmetric information leading to adverse selection. Bacha, (1997) started with the contemporary stock company to illustrate the conflict of interest that leads to moral hazard articulating that while the shareholders interest is the maximization of entity's value, the interest of company's management is the maximization of utility to increase their benefit. Mudharaba venture according to him, has more severe risk as it is a combination of debt and equity. This could be explained by highlighting the features of Mudharaba that it is the profit cannot be accounted for until realization and capital recovery because the entrepreneur is obliged to return the capital upon winding up. This is due to the agency problem. The agency problem is an inherent problem in any delegation contract. It has been a problem since human beings started to form partnerships but in the contemporary corporate structure it has been highlighted by researchers since (Berle et al., 1932). As we saw earlier, Mudharaba has an agency problem as it involves delegating the business activities to the Mudharib and as far as the control is concern we suggested according to the Islamic legal reference that agency problem could be mitigated by preserving assets title. However, other types of agency contracts do not necessarily link to tangible asset; the main type of this agency is the contemporary stock company. Another source of the problem is the information asymmetry. Prior to the emergence of crowdfunding, information asymmetry has been a substantial concern for financial markets especially in equity finance where Leland & Pyle (1977) has explained that the average quality of projects offered to venture capitalists would affect the market existence. If venture capitalists cannot find a worth investing projects, intuitively, the market will not exist hence, the need for responsible and proper disclosure. Also the problem of information asymmetry and agency cost become more prevalent in startups where the information has not been compiled and the firm's structure has not been stabilized especially when the firm in question is a technological one (Gilson, 2003; Ibrahim, 2015). Looking at equity finance risk we have to look at the methods obtained by Venture Capital (VS) to mitigate these risks. Joint venture capitalists mitigate the adverse selection risk by obtaining a stringent mechanism so that only 1% of the applications will be approved (P. A. Gompers et al., 2007). This methodology include assessment of the management team, the concept, the marketplace, fit with the fund’s objectives, the value added potential for the

Working Paper Series 2017 firm, and the capital needed to build a successful business (NVCA, 2016). Other means to protect VC investment include a gradual conditional disbursement on some performance criteria and some control or step-in rights in case of indications of misconduct (P. A. Gompers et al., 2007). This was also highlighted by (Ibrahim, 2015; Gilson, (2003) i.e. the fact that VCs use detailed contracts and conditional staged fund disbursement as well as taking a decisive interest in the firm that they have the power to appoint the board. In fact, it is to the extent that some literature say that in contradiction with Berle-Means concept that owners have less control in corporate structure venture capitalist have more control than what usual in contemporary corporation (Gilson, 2003). Going to Crowdfunding, we highlight the main risk mitigation methodologies obtained by equity crowdfunding platforms and imposed by regulators. These methods include limiting the amount that investors can invest at one year imposing some disclosure requirements on startups and platforms especially when the platform is responsible of due diligence. All these methods will appear in more detail in the findings

Methodology This paper employs a qualitative method which is prepared through document analysis and organizational comparison to decide the level of similarity and difference between equity crowdfunding and Investment Account Platform. The sample studied was focusing on Malaysia, Australia, UK and USA all these jurisdictions selected has one of two features either a matured crowdfunding market or special regulations toward crowdfunding

Finding and Recommendations The study has found that equity crowdfunding platforms obtain one of two approaches either doing the due diligence internally and not list any company that the platform doesn’t have reasonable belief that is genuine potential or disclosing as much as possible of the company’s information and leave the stringent due diligence to the investors. The fist method is obtained by Crrowdcube and platforms operating under Title II JOBS act in the US. The second method was obtained by ASSOB a platform in Australia. Nevertheless all studied sample has agreed that the amount investable by any investor should be limited so that it doesn’t exceed certain tolerable loss of the annual income or net worth. IAP however had a very distinctive feature which is credit rating for by independent agency which we saw as sign that the financing done is not entirely according to equity criteria despite the commendable risk mitigation methodology but the disbursement of fund still substantially differ form equity crowdfunding. We recommended that the assignment of assessment by kept to the credit rating agency with the incorpopration of investment committee with investment analysis competencies in the agency so that the efficiency is maintained but it will be skewed more towards equity concern rather than equity concern.

Conclusion

Working Paper Series 2017 The changing financial spectrum impose new challenges especially the banking sector. It is becoming easier to raise fund and to invest with high rate of engagement through equity crowdfunding portals. This change is in favor of the demand of more equity Islamic finance. Realizing that, Bank Negara Malaysia along with six local banks has formed IAP a Fintechbased-bank-intermediated investment and fundraising tool. As unique as the initiative, it is important to ascertain both the achieving of equity principle and maintaining moderate risk level for the public. It is clear then that IAP has managed to mitigate the risk in more efficient manner compared to equity crowdfunding. Nevertheless, this ability in risk mitigation is still hindering the platform from becoming the equity financial tool that stakeholders aspire to. The return is limited compared to equity crowdfunding that investors don’t benefit from the upside and the credit rating is still hard to achieve by most of the startups. With the hope in the future that the credit rating will be shifted towards more investment concerned assessment, we can see a bright future for IAP. Reference Bacha, O. (1997). Adapting mudarabah financing to contemporary realities: a proposed financing structure, (12732). Retrieved from https://mpra.ub.uni-muenchen.de/12732/ Berle, A. A., Means, G. G. C., Lin, C., Ma, Y., Malatesta, P., Xuan, Y., … Majluf, N. S. (1932). The Modern Corporation and Private Property [Transaction Publishers, 1991]. Journal of Financial Economics, 8(2), 187–221. https://doi.org/10.2139/ssrn.46906 Gilson, R. J. (2003). Engineering a Venture Capital Market: Lessons from the American Experience. Stanford Law Review, 55(4), 1067. https://doi.org/10.2139/ssrn.353380 Gompers, P. A., Lerner, J., Silviera, R., & Wright, R. (2007). The Venture Capital Cycle. Working Paper Available at https://www.aeaweb.org/assa/2009/retrieve.php?pdfid=11, 36. Retrieved from https://books.google.com/books?hl=en&lr=&id=yEAcswbX1fEC&pgis=1 Ibrahim, D. M. (2015). Equity crowdfunding: A market for lemons? Minnesota Law Review, 100(2), 561–607. https://doi.org/10.2139/ssrn.2539786 Leland, H. E., & Pyle, D. H. (1977). Informational Asymmetries, Financial Structure, and Financial Intermediation. The Journal of Finance, 32(2), 371–387. https://doi.org/10.2307/2326770

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